Introduction

The "Financials" sector is a broad sector that covers a variety of different financial institutions. The best way to define the sector is with Standard and Poors' "Global Industry Classification Standard® (GICS®)," which is the most widely used standard for separating stocks into industry sectors.

The GICS system classifies all stocks using a four-level system that starts with a "Sector" level, such as Financials. The Financials sector is then broken down into four Industry Groups: Banks, Diversified Financials, Insurance, and Real Estate. These Industry Groups are then further divided into the following Industry and Sub-Industry categories:

Banks

Commercial Banks – Diversified Banks

Commercial Banks – Regional Banks

Thrifts & Mortgage Finance

Diversified Financials
Diversified Financial Services

Other Diversified Financial Services

Multi-Sector Holdings

Specialized Finance

Consumer Finance

Consumer Finance

Capital Markets

Asset Management & Custody Banks

Investment Banking & Brokerage

Diversified Capital Markets

Insurance

Insurance Brokers

Life & Health Insurance

Multi-line Insurance

Property & Casualty Insurance

Reinsurance

Real Estate

Real Estate Investment Trusts (REITs)

Real Estate Management & Development

We will now discuss the Financial sector ETFs divided into several different classes, including Broad Financials, Leveraged/Short Financials, Financial Sub-Sectors, and Global Financials, among others. We will cover Real Estate exchange-traded products in a separate report.

U.S. Broad Financials ETFs

Financial Select Sector SPDR Fund (XLF) (issuer web site link) – This fund, launched in December 1998, has $7.7 billion in assets under management. The fund has an expense fee of 0.20%. The fund tracks publicly traded equity securities of companies in the Financial Select Sector Index. The fund holds 81 U.S.-listed stocks. The five top holdings are: JP Morgan Chase (9.1%), Wells Fargo (8.2%), Citigroup (6.5%), Bank of America (5.8%), and Goldman Sachs (3.8%). The industry weights in the fund are about 50% in Diversified, 20% in Insurance, 20% in Banks, and 15% in Real Estate.

Vanguard Financials Index Fund (VFH) (issuer web site link) – This fund, launched in January 2004, has $620 million in assets under management. The fund has an expense fee of 0.27%. The fund tracks the MSCI U.S. Investable Market Financials 25/50 Index, which is a subset of the MSCI U.S. Investable Market 2500 Index. The 25/50 in the name refers to a rule to make sure the index meets the Regulated Investment Company (RIC) diversification rules. The rule is that no more than 25% of the value of the fund's assets may be invested in a single stock and that the sum of the weights of all the stocks having a weight of more than 5% cannot together exceed 50% of the fund's total assets. The fund holds 501 U.S.-listed stocks. The five top holdings are: JP Morgan Chase (7.6%), Wells Fargo (6.6%), Bank of America (5.6%), Citigroup (5.4%), and Goldman Sachs (3.2%).

iShares Dow Jones US Financial Sector Index Fund (IYF ) (issuer web site link) – This fund, launched in May 2000, has $510 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the Dow Jones U.S. Financials Index. The fund holds 263 U.S.-listed stocks. The five top holdings are: JP Morgan Chase (7.6%), Wells Fargo (6.1%), Citigroup (5.5%), Bank of America (5.3%), and Berkshire Hathaway (3.4%).

First Trust Financial AlphaDEX Fund (FXO) (issuer web site link) – This fund, launched in May 2007, has $110 million in assets under management. The fund has an expense fee of 0.70%. The fund tracks the StrataQuant Financials Index, which uses the StrataQuant methodogy to select financial stocks from the Russell 1000 index. The fund holds 154 U.S.-listed stocks. The five top holdings are: Fidelity National Financial (1.2%), Assured Guaranty (1.1%), Chubb (1.1%), Travelers Companies (1.1%), and Nasdaq OMX Group (1.1%).

Smaller U.S. Broad Financials ETFs with under $50 million in assets

The following four Financials sector ETFs currently have less than $50 million in assets under management. We generally advise investors to avoid ETFs with less than $50 million in assets due to questions about the survival of the fund.

RevenueShares Financials Sector Fund (RWW) (issuer web site link) – This fund, launched in November 2008, has $11 million in assets under management. The fund has an expense fee of 0.49%. The fund selects the same stocks as are in the S&P 500 Financials Index, but then weights those stocks based on the relative weight of their revenue rather than their market capitalization. The fund holds 81 U.S.-listed stocks. The five top holdings are: Berkshire Hathaway (9.9%), Bank of America (9.0%), JP Morgan Chase (8.6%), Wells Fargo (6.9%), and Citigroup (6.9%).

Rydex S&P Equal Weight Financial ETF (RYF) (issuer web site link) – This fund, launched in November 2006, has $19 million in assets under management. The fund has an expense fee of 0.50%. The fund tracks the S&P 500 Equal Weight Financials Index. The fund holds 82 U.S.-listed stocks in roughly equal weights near 1.3%.

Our pick for a U.S. Broad Financials ETF: Our pick in the U.S. Broad Financials group is the Vanguard Financials Index Fund (VFH). We would normally have chosen the Financial Select Sector SPDR Fund (XLF) because it is far bigger than the Vanguard's VFH and because its expense fee of 0.20% is slightly lower than Vanguard's 0.27%. However, Vanguard's VFH has consistently outperformed XLF on the monthly, weekly and daily charts. Figure 1 illustrates the outperformance on the monthly chart. In order to see the weekly and daily charts, simply click on the "Live Chart Link" and on the chart on the Barchart.com web site, change the "Frequency" to "Weekly" and then "Daily." Another advantage is that Vanguard customers can trade VFH commission free.

We also like the greater diversification offered by the Vanguard fund, which holds 501 stocks at present versus only 81 for XLF. This means that Vanguard's VFH puts a lower weight on the financial behemoths of JP Morgan Chase, Citigroup, Bank of America, et al, and puts a greater weight on mid-sized and smaller financial firms. In this post-crisis environment, the financial behemoths remain under regulatory pressure to boost capital and strip down their riskier operations so that they are not in the "too big to fail" category, and this may hurt their profitability and their stock prices relative to the mid-sized and smaller financial firms that are under the radar regarding too-big-to-fail.

Leveraged Long Broad Financial ETFs

There are two very large ETFs in the Leveraged Long Broad Financials class, as described below. These two ETFs cannot be directly compared on a chart because Direxion's FAS has 300% leverage whereas ProShare's UYG has 200% leverage, meaning that FAS will produce significantly better and worse returns that UYG simply because it has higher leverage. The two funds have the same expense fee. The choice between the two basically comes down to whether an investor is looking for 200% or 300% leverage.

Direxion Financial Bull 3X Shares (FAS) (issuer web site link) – This fund, launched in November 2008, has $1.4 billion in assets under management. The fund has an expense fee of 0.95%. The fund seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000 Financial Service Index.

ProShares Ultra Financials (UYG) (issuer web site link) – This fund, launched in January 2007, has $1 billion in assets under management. The fund has an expense fee of 0.95%. The fund seeks a return of 200% of the daily price performance of the Dow Jones U.S. Financials Index.

Short Broad Financial ETFs

There are three ETFs that provide short exposure to the broad Financials sector. The funds are fairly similar, all with expense fees of 0.95%. The choice for an investor comes down to whether 100%, 200% or 300% leverage is desired.

Direxion Financial Bear -3X Shares (FAZ) (issuer web site link) – This fund, launched in November 2008, has $620 million in assets under management. The fund has an expense fee of 0.95%. The fund seeks daily investment results, before fees and expenses, of 300% of the inverse of the price performance of the Russell 1000 Financial Service Index. This is the short version of the Direxion Financial Bull 3X Shares (FAS) described above.

ProShares UltraShort Financials (-2X) (SKF) (issuer web site link) – This fund, launched in January 2007, has $340 million in assets under management. The fund has an expense fee of 0.95%. The fund seeks investment returns, before fees and expenses, of 200% of the inverse performance of the Dow Jones U.S. Financials Index.

ProShares Short Financials (-1X) (SEF) (issuer web site link) – This fund, launched in June 2008, has $110 million in assets under management. The fund has an expense fee of 0.95%. The fund seeks daily investment results, before fees and expenses, of 100% of the Dow Jones U.S. Financials Index. This is the unleveraged version of the ProShares UltraShort Financials ETF (SKF) described above.

Financial Sub-Sector - Banks

There are two ETFs that focus on just the Bank Industry Sector, thus excluding the other Industry Sectors of Diversified Financials, Insurance, and Real Estate. In this class, the SPDR KBW Bank ETF is the clear choice since it has $1.4 billion in assets, whereas the PowerShares Dynamic Banking Sector Portfolio (PJB) has only $15 million in assets and its survival is at risk.

SPDR KBW Bank ETF (KBE) (issuer web site link) – This fund, launched in November 2005, has $1.4 billion in assets under management. The fund has an expense fee of 0.35%. The fund tracks the KBW Bank Index. The fund holds 26 U.S.-listed stocks. The five top holdings are: JP Morgan Chase (8.6%), Citigroup (6.9%), Wells Fargo (6.8%), US Bancorp (6.2%), and Bank of America (5.9%).

PowerShares Dynamic Banking Sector Portfolio (PJB) (issuer web site link) – This fund, launched in October 2006, has only $15 million in assets under management. The fund has an expense fee of 0.65%. The fund tracks the Dynamic Banking Intellidex Index. The fund holds 30 U.S.-listed stocks. The five top holdings are: PNC Financial (5.2%), M&T Bank (5.2%), JP Morgan Chase (4.8%), U.S. Bancorp (4.8%), and SunTrust Banks (4.7%).

Financial Sub-Sector – Regional & Community Banks

SPDR KBW Regional Banking ETF (KRE) (issuer web site link) – This fund, launched in June 2006, has $515 million in assets under management. The fund has an expense fee of 0.35%. The fund tracks the KBW Regional Banking Index, which is an equal-weighted index. The fund holds 51 U.S.-listed stocks. The five top holdings are: SVB Financial (2.9%), Associated Banc (2.7%), Whitney Holdings (2.7%), Wintrust Financial (2.6%), and Community Bank System (2.5%).

iShares Dow Jones US Regional Banks Index Fund (IAT) (issuer web site link) – This fund, launched in May 2006, has $130 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the Dow Jones U.S. Select Regional Banks Index. The fund holds 64 U.S.-listed stocks. The five top holdings are: US Bancorp (18.1%), PNC Financial (12.2%), BB&T (6.9%), Suntrust Banks (5.3%), and Fifth Third Bancorp (4.4%).

First Trust NASDAQ ABA Community Bank Index Fund (QABA) (issuer web site link) – This fund, launched in June 2009, has $13 million in assets under management. The fund has an expense fee of 0.60%. The fund tracks the NASDAQ OMX ABA Community Bank Index. The fund holds 95 U.S.-listed stocks. The five top holdings are: People's United Financial (5.0%), First Niagara Financial (4.4%), Zions Bancorp (4.4%), Commerce Bancshares (3.8%), and BOK Financial (3.7%).

Our pick for a regional Bank ETF -- There are three ETFs covering the regional and community banking sector. Our pick in this class is the SPDR KBW Regional Banking ETF (KRE). This fund's expense fee of 0.35% is lower than the iShare's IAT fund's fee of 0.48%. We also like the equal-weighted nature of SPDR's KRE, which provides equal exposure to large as well as small regional banks. By contrast, iShares' IAT has a high concentration in stocks such as US Bancorp (18.1%), PNC Financial (12.2%), and BB&T (6.9%).

Regional Bank Sector ETFs - Leveraged Long and Short

ProShares, trying to piggyback on the success of the SPDR KBW Regional Banking ETF (KRE), runs a short (-1X) ETF and leveraged long (+2X) ETF based on the same index of the KBW Regional Banking Index. However, neither of these funds has gathered significant assets as yet.

ProShares Short KBW Regional Banking (-1X) (KRS) (issuer web site link) – This fund, launched in April 2010, has $22 million in assets under management. The fund has an expense fee of 0.95%. The fund seeks daily investment results, before fees and expenses, equal to 100% of the inverse of the performance of the KBW Regional Banking Index.

ProShares Ultra KBW Regional Banking (2X) (KRU) (issuer web site link) – This fund, launched in April 2010, has $4 million in assets under management. The fund has an expense fee of 0.95%. The fund seeks daily investment results, before fees and expenses, equal to 200% of the price performance of the KBW Regional Banking Index.

Financial Sub-Sector – Mortgage Finance

SPDR KBW Mortgage Finance ETF (KME) (issuer web site link) – This fund, launched in April 2009, has $4 million in assets under management. The fund has an expense fee of 0.35%. The fund tracks the KBW Mortgage Finance Index, which focuses on the mortgage banking, processing, and marketing segment of the U.S. financial services industry. The fund holds 25 U.S.-listed stocks. The five top holdings are: Hudson City Bancorp (7.6%), DR Horton (7.3%), Popular Inc (7.1%), Toll Brothers (7.0%), and Old Republic (5.5%). While this ETF provides exposure to a specific area of possible interest to investors, it has little more than its seed money under management and investors should therefore be wary of its survival.

Financial Sub-Sector – Broker-Dealers & Capital Markets

iShares Dow Jones US Broker-Dealers Index Fund (IAI) (issuer web site link) – This fund, launched in May 2006, has $155 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the Dow Jones U.S. Select Investment Services Index. The fund holds 27 U.S.-listed stocks. The five top holdings are: Goldman Sachs (8.6%), Morgan Stanley (7.1%), CME Group (7.1%), Schwab (5.9%), and Ameriprise Financial (5.8%).

SPDR KBW Capital Markets ETF (KCE) (issuer web site link) – This fund, launched in November 2005, has $65 million in assets under management. The fund has an expense fee of 0.35%. The fund tracks the KBW Capital Markets Index. The fund holds 26 U.S.-listed stocks. The five top holdings are: State Street (7.9%), Franklin Resources (7.9%), Morgan Stanley (6.3%), CME Group (6.3%), and Goldman Sachs (6.3%).

Our pick for a Broker-Dealer/Capital Markets ETF – These ETFs provide specific exposure to financial firms that specialize in brokerage and trading and even include exchanges such as the CME Group. Our choice in this sector is iShares Dow Jones US Broker-Dealers Index Fund (IAI). While iShares' IAI has an expense fee of 0.48% that is higher than SPDR's KCE of 0.35%, iShares' IAI has substantially more assets under management at $155 million. SPDR's KCE, by contrast, is only modestly above our suggested minimum asset level of $50 million. Both funds have fairly similar performance on monthly, weekly and daily charts. Figure 2 shows a weekly chart, but click on the live chart link and then change the "Frequency" field to "Weekly" and "Daily" to see how the performance (as of this report date) is fairly similar.

Financial Sub-Sector – Insurance

SPDR KBW Insurance ETF (KIE) (issuer web site link) – This fund, launched in November 2005, has $200 million in assets under management. The fund has an expense fee of 0.35%. The fund tracks the KBW Insurance Index. The fund holds 26 U.S.-listed stocks. The five top holdings are: Metlife (9.3%), Travelers Companies (8.2%), Prudential (7.0%), Aflac (6.5%), and Aon Corp (5.4%).

iShares Dow Jones U.S. Insurance Index Fund (IAK) (issuer web site link) – This fund, launched in May 2006, has $95 million in assets under management. The fund has an expense fee of 0.47%. The fund tracks the Dow Jones U.S. Select Insurance Index. The fund holds 63 U.S.-listed stocks. The five top holdings are: Metlife (10.2%), Prudential Financial (8.6%), Travelers Cos (7.5%), Aflac (6.6%), and Ace (6.5%).

PowerShares Dynamic Insurance Portfolio (PIC) (issuer web site link) – This fund, launched in October 2005, has $8 million in assets under management. The fund has an expense fee of 0.63%. The fund tracks the Insurance Intellidex Index. The fund holds 30 U.S.-listed stocks. The five top holdings are: Chubb (5.5%), Progressive (5.4%), Travelers Companies (5.3%), Unum Group (5.1%), and Aon Corp (5.0%).

Our pick for an Insurance ETF – Our pick for an Insurance ETF is SPDR KBW Insurance ETF (KIE). SPDR's KIE has the most assets under management in the class and also has a lower expense fee of 0.35% than the expense fee for the iShares Dow Jones US Insurance Index Fund (IAK) of 0.47%. In addition, as illustrated in Figure 3, SPDR's KIE has shown better performance on the monthly chart.

Global Financials

iShares S&P Global Financials Sector Index Fund (IXG) (issuer web site link) – This fund, launched in November 2001, has $265 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the S&P Global Financials Sector Index. The fund holds 218 globally-listed stocks. The five top holdings are: HSBC Holdings (3.6%), JP Morgan Chase (3.5%), Wells Fargo (3.0%), Berkshire Hathaway (2.7%), and Citigroup (2.4%). The fund has an industry breakdown of 46.5% in banks, 24.6% in Diversified Financials, 20.1% in Insurance, and 8.2% in Real Estate. The holdings by country are 36.62% in the U.S., 9.31% in the U.K., 8.00% in Austrlia, 7.58% in Canada, 5.97% in Japan, 4.38% in Switzerland, 4.02% in France, 3.30% in Germany, 3.27% in Spain, and 17.00% in other countries Asia, Europe and South America.

SPDR S&P International Financial Sector ETF (IPF) (issuer web site link) – This fund, launched in July 2008, has $4 million in assets under management. The fund has an expense fee of 0.50%. The fund tracks the S&P Developed Ex-U.S. BMI Financials Sector Index. The fund holds 135 globally-listed stocks of banks that are based outside the U.S. The five top holdings are: HSBC Holdings (5.1%), Commonwealth Bank of Australia (2.7%), Banco Santander (2.7%), BNP Paribas (2.5%), and Royal Bank of Canada (2.4%).

iShares MSCI ACWI ex US Financials Sector Index Fund (AXFN) (issuer web site link) – This fund, launched in January 2010, has $2 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the MSCI All Country World ex USA Financials Index. The fund holds 269 globally-listed stocks. The five top holdings are: HSBC Holdings (4.4%), Banco Santander (2.4%), Commonwealth Bank of Australia (2.0%), Royal Bank of Canada (2.0%), and Toronto-Dominion Bank (1.8%).

Our pick for both the Global Financials group and the entire Financials sector – Our pick for the Global Financials class is the iShares S&P Global Financials Sector Index Fund (IXG). IXG is the only ETF in the Global Financials class that has significant assets under management. Nevertheless, we believe IXG makes a good choice for a Global Financials ETF in terms of expense fees and return.

In fact, we are choosing iShares S&P Global Financials Sector Index Fund (IXG) as our pick for the entire Financials sector because we like the exposure and diversification that IXG provides to other major financial firms in the world as opposed to ETFs that focus only on U.S.-listed firms. In addition, iShares' IXG has shown better performance that our U.S. Financials ETF pick of Vanguard Financials Index Fund (VFH), as seen in Figure 4. Academic studies have shown that U.S. investors typically are underexposed to global equities relative to optimal levels and ETFs are an ideal way to obtain global exposure with little fuss since the ETF trades in dollars and the ETF fund takes care of buying overseas stocks that trade in other currencies.

Specific Non-U.S. Regions - Financials

None of the ETFs in this group has significant assets under management and we do not recommend investing in any of these ETFs at present. However, these ETFs cover areas of rapid growth and therefore bear watching for the possibility that they will be able to build their assets under management.

iShares MSCI Europe Financials Sector Index Fund (EUFN) (issuer web site link) – This fund, launched in January 2010, has $7 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the MSCI Europe Financials Index. The fund holds 107 stocks of financial institutions that are based in Europe. The five top holdings are: HSBC Holdings (11.0%), Banco Santander (6.0%), UBS (4.7%), BNP Paribas (4.3%), and Allianz (4.0%).

iShares MSCI Far East Financials Sector Index Fund (FEFN) (issuer web site link) – This fund, launched in January 2010, has $2 million in assets under management. The fund has an expense fee of 0.48%. The fund tracks the MSCI Far East Financials Index. The fund holds 85 stocks of banks that are based in the Far East. The five top holdings are: Mitsubishi (8.7%), Sumitomo Mutsui Financial (6.1%), Mizuho Financial (4.6%), Cheung Kong Holdings (3.7%), and Sun Hung Kai Properties (3.7%).

Global X China Financials ETF (CHIX) (issuer web site link) – This fund, launched in December 2010, has $5 million in assets under management. The fund has an expense fee of 0.65%. The fund tracks the Solactive China Financials Index. The fund holds 25 stocks of financial institutions that are based in China. The five top holdings are: Industrials & Commercial Bank of China (11.0%), China Construction Bank (10.1%), Bank of China (9.6%), China Life Insurance (8.5%), and Agriculture Bank of China (5.0%).

Financial Preferred Stocks

PowerShares Financial Preferred Portfolio (PGF) (issuer web site link) – This fund, launched in December 2006, has $1.8 billion in assets under management. The fund has an expense fee of 0.65%. The fund tracks the Wells Fargo Hybrid and Preferred Securities Financial Index. The fund holds only preferred or hybrid securities. The five top holdings are: HSBC Holdings 8% PFD (10.1%), Bank of America (7.6%), HSBC Holdings (5.7%), ING (5.5%), and Bank of America 8.625% PD (4.8%). This fund, which holds substantial assets under management of $1.8 billion, can be a good choice for investors who are specifically looking for income-oriented preferred and hybrid securities that are issued by global financial institutions.

Financial Sub-Sector – Private Equity

PowerShares Global Listed Private Equity Portfolio (PSP) (issuer web site link) – This fund, launched in October 2006, has $420 million in assets under management. The fund has a very high expense fee of 2.95%. The fund tracks the Global Listed Private Equity Index. The fund holds 61 globally-listed private equity companies. The five top holdings are: Ratos AB (4.9%), Leucadia National Corp (4.9%), 3i Group (4.4%), Wendel (4.4%), and Onex Corp (4.2%). This ETF can be a good choice for investors who are looking for an easy way to invest in publicly-listed business development companies and financial institutions whose principal business is to invest in and lend capital to privately held companies.